Over the past year, directors and officers have been anticipating the Supreme Court’s ruling in Halliburton Co. et al. v. Erica John Fund, Inc., No. 13-317. In its recent 9-0 decision, the Supreme Court retained the fraud-on-the-market presumption of reliance adopted more than 25 years ago in Basic, Inc. v. Levinson, yet also held that defendants may rebut the presumption at the class certification stage. 573 U S. ___ (Slip Op. June 23, 2014) (Roberts, C.J.). This ruling signals that securities fraud class actions will continue unabated for the foreseeable future. Justice Ginsburg concurred in a separate opinion, joined by Justice Breyer and Justice Sotomayor. Justice Thomas also concurred in a separate opinion, joined by Justice Alito and Justice Scalia.
The Basic Background: The Fraud-on-the-Market Theory
To establish liability in a securities fraud case, an investor must prove, among other things, that he relied on the defendant’s misrepresentation in deciding to purchase or sell securities. In its 1988 ruling in Basic, Inc. v. Levinson, 485 U.S. 224 (1988), the Supreme Court held that investors could satisfy this requirement by invoking a rebuttable presumption of reliance premised on the expectation that the price of stocks traded in an efficient market reflects all public, material information. As established in Basic, the “fraud-on-the-market” theory provides that any investor that buys or sells stock in an efficient market is presumed to have relied on the publicly available information, including the company’s misstatements.
The Genesis of the Halliburton Litigation
In Halliburton, Erica P. John Fund, Inc. (EPJ Fund) filed a putative class action against Halliburton and one of its executives, alleging violations of section 10(b) of the Securities Exchange Act of 1934 and Securities and Exchange Commission Rule 10b–5. According to EPJ Fund, Halliburton misrepresented its potential liability in asbestos litigation, its expected revenue from certain construction contracts, and anticipated benefits from a merger in an attempt to inflate its stock price. EPJ Fund moved to certify a class of all investors that purchased Halliburton stock during the relevant class period. The District Court refused to certify the class and the 5th Circuit affirmed. The Supreme Court vacated and remanded the Circuit Court’s decision and held that securities fraud plaintiffs were not required at the class certification stage to prove “loss causation” between the defendants’ alleged misrepresentations and the plaintiffs’ economic losses to invoke Basic’s presumption of reliance. They retained that burden, however, at the merits stage of the case.
On remand, Halliburton argued that class certification was inappropriate because it had rebutted the presumption of reliance by demonstrating that the misrepresentations lacked any “price impact.” Halliburton argued that, absent the presumption, each investor would be required to prove reliance and individual issues would predominate over common issues. The District Court rejected Halliburton’s argument and certified the class. Once again, the 5th Circuit affirmed.
The Supreme Court granted certiorari, both to reconsider the presumption of reliance and to resolve a circuit split concerning whether securities fraud defendants may assert lack of price impact to rebut the Basic presumption at the class certification stage.
Halliburton Reaffirms Basic
The Court held that Halliburton failed to demonstrate the special justification necessary to overrule the long-settled precedent embraced by Basic. As an initial matter, Chief Justice Roberts, writing for the Court, rejected Halliburton’s argument that the fraud-on-the-market theory is inconsistent with congressional intent, explaining that this argument was no more persuasive than it was before the Court in Basic.
The Chief Justice further rejected Halliburton’s argument that the present economic climate cannot be reconciled with the principles underlying the fraud-on-the-market theory. Although the opinion acknowledged the imperfections of the efficient capital markets hypothesis, it concluded that the majority of investors nonetheless rely on the information publicly available in the marketplace. According to the Chief Justice, even if the information disseminated to the public is inaccurate, it will impact the stock price. Chief Justice Roberts reasoned that, while empirical evidence may create doubt as to whether capital markets are fundamentally efficient, debate over economic theory and statistical analysis was similarly present when Basic was decided. Yet, “recognizing that market efficiency is a matter of degree,” the Basic Court had “declined to enter the fray” and “instead based the presumption on the fairly modest premise that ‘market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices.’” Slip Op. at 10.
In response to Halliburton’s contention that the Basic presumption relaxed the requirements of proving class certification, the Court explained that “Basic instead establishes that a plaintiff satisfies that burden by proving the prerequisites for invoking the presumption – namely, publicity, materiality, market efficiency, and market timing.” Slip Op. at 14. Finally, the Court concluded that Halliburton should direct to Congress any concerns regarding the risks posed by potentially frivolous class action claims.
The Court Takes the Middle Ground
In an alternative to its argument to eliminate the fraud-on-the-market theory, Halliburton suggested either: (1) imposing an affirmative burden on plaintiffs to prove price impact or (2) permitting defendants – before the class certification stage – to rebut the presumption of reliance with evidence of a lack of price impact.
The Court rejected Halliburton’s attempts to demonstrate that an affirmative showing of price impact was warranted, noting that such a requirement would “radically alter the required showing for the reliance element of the Rule 10b-5 cause of action.” Slip Op. at 17. Chief Justice Roberts instead reasoned that permitting defendants to rebut the presumption affords adequate protection and recognized that “[i]n the absence of price impact, Basic’s fraud-on-the-market theory and presumption of reliance collapse.” Slip Op. at 17.
Importantly however, the Court agreed with Halliburton that defendants should be permitted to rebut the presumption of reliance not only on the merits, but also at the class certification stage. Recognizing that, under the Court of Appeals ruling, securities fraud plaintiffs and defendants may submit price impact evidence prior to class certification, but may not rely on such evidence to rebut the presumption of reliance, the Chief Justice stated that “[t]his restriction makes no sense, and can readily lead to bizarre results.” Slip Op. at 19. Rather, the Court stated:
Price impact is thus an essential precondition for any Rule 10b-5 class action. While Basic allows plaintiffs to establish that precondition indirectly, it does not require courts to ignore a defendant’s direct, more salient evidence showing that the alleged misrepresentation did not actually affect the stock’s market price and, consequently, that the Basic presumption does not apply.
Slip Op. at 21. The Court also ruled that its judgment did not conflict with the Court’s ruling in Amgen, Inc. v. Connecticut Retirement Plans & Trust Funds, No. 11-1085 (Slip Op. Feb. 27, 2013), which held that materiality is properly addressed at the merits stage of a securities fraud action. The lead opinion explained that while materiality is “an objective issue susceptible to common, classwide proof .... [p]rice impact is different. The fact that a misrepresentation ‘was reflected in the market price at the time of [the] transactions’ – that is had price impact – is ‘Basic’s fundamental premise’ …. It thus has everything to do with the issue of predominance at the class certification stage.”
Slip Op. at 21-22.
Justice Ginsburg’s Concurring Opinion
In a brief concurring opinion, Justice Ginsburg acknowledged the possibility that the Court’s decision may broaden the scope of discovery available at the class certification stage, yet concluded that the judgment “should impose no heavy toll on securities-fraud plaintiffs with tenable claims.”
Justice Thomas’s Concurring Opinion
Though labeled a “concurring opinion” Justice Thomas concluded that Basic should be overruled, insofar as “[l]ogic, economic realities, and our subsequent jurisprudence have undermined the foundations of the Basic presumption, and stare decisis cannot prop up the facade that remains.” Justice Thomas asserted that the premise that investors rely on the integrity of the market price is “simply wrong” and that the presumption of reliance “exempts Rule 10b-5 plaintiffs from Rule 23’s proof requirements.” According to Justice Thomas, the market’s failure to digest publicly available information comprehensively and accurately reflects essential flaws in the efficient market hypothesis. Specifically, Justice Thomas expressed his view that the ruling in Basic cannot be reconciled with the reality that many investors are motivated by considerations unrelated to the information publicly available in the marketplace, such as tax concerns, changing liquidity needs, or a belief that a stock has been over- or undervalued. Though clearly troubled by the persistence of the fraud-on-the-market theory, Justice Thomas concluded that “[t]ime and experience have pointed up the error of [the Basic] decision, making it all too clear that the Court’s attempt to revise securities law to fit the alleged ‘new realities of financial markets’ should have been left to Congress.” Justice Thomas and the two Justices joining his opinion nevertheless concurred in the result.
Assessing the Impact of Halliburton
By retaining the fraud-on-the-market theory and permitting defendants to rebut the presumption of reliance at the class certification stage, the Supreme Court struck a middle ground that will leave securities fraud class actions intact, albeit with an additional hurdle that may increase defense costs and limit some suits. The alternative of overruling Basic would have made it impossible to certify an investor class in most 10b-5 cases due to the individualized nature of actual reliance.
This decision does not throw out Basic’s presumption of reliance or reject the efficient market hypothesis, which is the subject of longstanding debate in the economics community. Instead, it allows plaintiffs to continue to plead and prove the elements necessary to invoke the presumption of reliance, but makes clear that defendants may offer evidence that their statements had no price impact to rebut the presumption at, or prior to, the class certification stage.
The Supreme Court’s decision presents somewhat mixed news for defendants and their D&O insurers. Although accelerating the time at which defendants can rebut the presumption of reliance ultimately may permit certain defendants to avoid certification – the functional equivalent of dismissal – attaining this benefit will require thoughtful, comprehensive discovery, use of damages experts armed with event studies, and more stringent inquiry at the class certification stage. This process will increase the amount of defense costs payable by the insurers and may increase the settlement values of those cases that survive the challenge. Additionally, lower courts will be left to litigate the issues unresolved by the Court, including what constitutes price impact, and what types of evidence can be presented to demonstrate the lack of price impact. The only certainty is that, at least for the time being, the Supreme Court’s decision will quell the debate among litigants over the continued viability of the fraud-on-the-market theory.